What is Private Equity (PE)?
A PE fund is a financial intermediary typically formed as limited partnerships
A PE fund invests only in private (or soon-to-be-private) companies
Important to have good VCs for good returns!
Gompers et al 2020 find that:
When selecting deals, VCs place the greatest importance on the management team.
VCs devote substantial resources to deal sourcing, selection, and post-investment value-add.
Most VCs do not use discounted cash flow (DCF) or net present value (NPV) techniques to evaluate investments. They rely more on valuation multiples and IRR.
After investing, VCs are actively involved with their portfolio companies.
VCs are generally inflexible on key economic terms in contracts like liquidation preferences, anti-dilution rights and vesting.
VC firms are small, with only 14 employees on average, half of whom are senior investment professionals. Most of their time is spent on sourcing and working with portfolio companies.
In contrast to VC, (Leveraged) Buyout (BO) funds focus on established firms
Firms are either private to begin with, or are taken private (as in a management buyout)
Large amounts of new debt are used to finance the repurchase of existing equity
There’s big demand: in 2020, LBO funds had 1.6 trillion dollars to spend on buyouts
Incentives of GPs and LPs may not always be aligned
GPs may have incentives to shirk or take excessive risk
Fees, co-investment by fund managers and covenants discipline GPs and protect the LPs
Fees include a flat rate (1-3%) plus 20-30% performance fee
Co-investment: General partners often required to personally invest in the funds (typically GP invests 1%)
Covenants: e.g. restrictions on activities
Private equity is, by definition, private – limited trading with no continuously posted price. How can we evaluate the risk return profile?
At the minimum, we need to at least evaluate the different return levels
Two main (and limited) ways in private equity:
Multiples is the value out divided by the initial payment in \[ M = \frac{\sum_{t=1}^{T}C_{1}}{P_0}\]
IRR you know quite well – accounts for timing of cash flows (payments)
\[ 0 = P_{0} + \sum_{t=1}^{T}\frac{C_{t}}{(1+r)^{t}}\]
The comparable results to the market prompt a simple comparison:
This is the private market equivalent (PME): the funds placed into PE fund are evaluated based on the opportunity cost of missing out on the market
This approach can be much better than just IRR or multiples, since it will account for the opportunity cost relative to the market
With PME, IRR, and multiples, can compare the relative return on investments (but not riskiness
How to identify good private equity funds?
Pick past winners!
Returns to private equity are highly persistent (Why?)
Issue: everyone wants to get in funds with strong performance
Often the binding constraint for successful PE funds is investment opportunities, not investors
Leads to money-chasing-deals phenomenon
During periods of high flows into private equity, funds pay higher valuations for their acquisitions